12 Concepts Every Investor Should Know
The world of investing is big, diverse and exciting! You have to learn how to save money and invest for a very simple reason – achieving financial freedom. Financial freedom means that you have enough money not only to cover the costs of your basic needs, such as food, community bills, insurance and others, but also to do whatever you choose to at any given stage of your life. Knowledge gives confidence. So, be ready to learn the rules and methods how to deal with your money intelligently. Now learn several major concepts every investor should be aware of from the beginning.
Financial goals make investing meaningful. Take time and think a bit about your life in the long run.
What you will do and where and how will you live?
What kind of expenses are ahead of you? How prepared are you to cover them?
What part of your earnings could you put aside for the future use?
When you have an idea of how much you would like to save, then the next question is: how to invest money? There are numerous ways to do it, depending on your risk tolerance. Moreover, it would be smart to do it in cost efficient and tax efficient ways.
The circumstances of each of us are different and the best person to find out and decide why, what and how is you. So, start digging into this area, learn, read books, consult with advisers, make conclusions and move on. Over time you will become good at it.
There is a big variety of financial products nowadays, including deposits, bonds, stocks, funds, ETFs, REITs and many others. Some of them are sophisticated products, others not. You may find definitions of some of the financial products in Glossary.
Those products bear different degree of risk. Generally riskier products have higher potential returns over time. For example, stocks are more volatile than bonds. At the same time over long term stocks tend to provide with higher rates of return than bonds.
Concept of compounding is very important for long term investors. Compound interest is the interest paid both on initial capital and the interest, accumulated over the previous period. Accumulating “interest on interest” allows invested money grow faster than in the case of the interest paid only on the initial invested sum. Here is an example of compounding.
Let’s suppose you invest EUR 100 for 5 years with 10% annual compound interest. In this case your money grows as follows:
End of Year 1
Initial Capital plus Interest Earned = 100+100*0.10 = 100*(1+0.10) = 110.
Now we have Eur 110 and grow this sum again with 10% interest over second year.
End of Year 2 110+110*0.10 = 110*(1+0.10) = 121
End of Year 3 121*(1+0.10) = 133,1
End of Year 4 133.1*(1+0.10) = 146.41
End of Year 5 146.41*(1+0.10) = 161.05
If you receive 10% each year only on your initial investment of EUR100, then each year you would receive EUR10 (10% 0f EUR100). So, in 5 years you would have EUR 50 interest earned and your initial capital, EUR100. In total EUR150. The difference between EUR 161.05 and EUR 150 is due to compounding effect. The longer you invest the bigger gets this difference. You can see that compounding allows your money grow faster.
The state of an economy has a huge impact on financial markets. Over time an economy moves in cycles. It expands, contracts and recovers again. Such waves have a length of anything from several months to several years and are difficult to predict. The state of an economy has a major effect on an environment in which companies function. So, when studying stocks and taking investment decisions we always should keep in mind what is the overall economic situation. We need to be familiar with economic factors and their influence on the market.
An economy is a network of producers, distributors and consumers in a country. It is a universe of production, trade and consumption activities. It is governed by a law and influenced by big variety of factors. Free market economy develops according to the law of supply and demand. If there is a demand, prices go up and resources are allocated to meet that demand.
Macroeconomics is concerned with a study of an economy on a country level (not a company or an industry levels). Macroeconomic indicators help to evaluate how economy moves as a whole, is it growing, stable or declining.
There are three main macroeconomic factors to follow: Gross Domestic Product, Inflation and Unemployment. The other useful indicators of economic activity are Investment and Savings. We discuss each of these factors in turn.
- Gross Domestic Product
As mentioned earlier, an economy moves up and down over time. It moves in business cycles, i.e., it expands, peaks, contracts and expands again. A business cycle is usually measured in terms of Gross Domestic Product (GDP). GDP measures country’s economic activity. It is measured as the sum of values in Euros of all goods and services produced in a country. The other way to determine GDP is to calculate it as a sum of government and consumer spending, all investments and total exports less total imports. It is calculated quarterly and annually. Then current GDP is compared with GDP from previous quarters or years. In this way it is judged whether economy is growing or declining. The comparison is more accurate if GDP is adjusted for inflation.
Inflation measures the increase in the general level of prices of goods and services. Prices increase over time so that more money is needed for purchasing the same goods or services. So, inflation reduces the purchasing power of money. Inflation is measured by Consumer Price Index (CPI), which tracks the price of a basket of certain core goods and services.
Deflation occurs when the general level of prices is reducing.
Governments try to avoid deflation and they aim inflation to around 2% in order to have economy growing for many years.
The unemployment rate is calculated as the number of unemployed persons divided by the number of persons in employment and expressed in percentage. Unemployment is high during recessions and low when economy is expanding. So, it is important factor to consider when evaluating the currrent state of business cycle.
Investment is the value of goods bought for the purpose of production of goods and services. Such investment leads to the increase in production of goods/services and, so, to the increase in GDP.
Savings is the amount of money which is not spent. It is person’s disposable income less expenses. National savings consist of personal, business and public savings. Personal savings are the largest part of national savings. So, individuals through their savings influence economy as follows.
- If savings are in a bank account, banks can finance business investments. So, investment can increase.
- If savings are invested in a stock market, they finance companies.
- If invested in Treasury bonds, they finance a public expenditure and so on.
Savings are higher during an economic expansion period since a growing income allows higher savings. Savings are lower during recessions.
Economy is influenced by government’s Monetary and Fiscal policies.
Monetary policy is carried out by central banks. It is implemented by managing interest rates and money supply in order to influence economic growth. Central bank buys or sells Government bonds to influence money supply. When it buys Government bonds, it injects money into economy and when sells, pulls money out. Through reserve ratios Central bank controls the amount of money banks create through loans. Central bank influences short term interest rate by charging certain interest rate on money borrowed to banks. So, Central bank can encourage or restrict spending and saving and influence in this way economic growth.
Fiscal policy is carried out by Government. Through fiscal policy Government tries to control economy by changing taxes and its expenditure. To avoid overheat during economic expansion, Government can apply higher taxes and reduce spending. Then disposable income would reduce and lead to lower demand. That in turn leads to reduction in GDP. In recession government can apply expansionary fiscal policy – reduce taxes and increase public spending. It fuels demand and leads to higher GDP.
You can see information and comments on the current state of business cycle on Home page of website.
Company is a legal entity, initially private, set by investors who provide money to launch business. After some years of activity company can go public. So other investors can get access to an ownership interest in a company or, in other words, buy stocks of a company. Shareholders returns depend on how profitable is company.
Company experiences the following stages over its life.
- Start Up
At this stage company develops product or service and starts its marketing and selling. Company balances to meet customer expectations and keep at the same time acceptable level of profitability. Customer base is gradually established. Company is small and business risks are high.
Customer base is gradually established. Business model is further developed to adapt to market conditions and prepare for business expansion. Company grows to medium sized. Revenue grows double digit percentage every year.
Market share increases, revenue and cash flow grow fast.
Company becomes large.
Company is one of the leaders within its industry.
Annual revenue growth slows to single digit percentage.
For some reasons company is not able to support growth. Revenue declines. It develops exit strategy or looks for new opportunities to start business expansion again.
Usually companies start to pay dividends at the expansion and maturity stages. So, majority of companies dividend investors consider are large and medium. Such companies do not grow as fast as small ones, have more stable business model and are more predictable in terms of performance.
Stock is a security that proves ownership in company. Investing in stocks in attractive to many investors because historically stocks provide the highest returns over long period of time compared to other alternatives. This is because over long period of time companies are able to create high economic value and reward generously their shareholders. Also, investing in stocks can provide protection against inflation. Inflation is one of the biggest threats for long term investor since it erodes the value of assets. History shows that over long term value of stocks grow more than inflation. Of course this goes along with the risk that investors can lose money through picking stocks since the prices of stocks are volatile. While investing in stocks you should assume that it is not unusual that stock loses 30% – 40% (or even more) of its value over period of several months or years. This price volatility can be reduced by investing in many stocks instead of just in one stock.
By gaining knowledge and experience in investing you can learn how to deal with risks and how to make your money work hard for you.
Stock market consists of stock exchanges where investors can trade stocks and other types of assets. The movements of market can be measured tracking stock indexes, like DAX30, CAC40 or IBEX35. Investment returns in stock market can be volatile. Stock market experiences waves in the same way as economy overall. For example, DAX 30 lost almost 26% in 2011 within the period from July 28 to September 14 and gained more than 26% over 2019. Markets ups and downs usually precede those of economy.
Despite a short term volatility, stocks are the best performing asset class over the long periods of time. The longer you invest in stocks, the less volatile your returns become and the higher returns you can expect. For example, DAX has average compound returns of 8.4% over the last 10 years. In annual returns highest was 2012 (+29.06%) and lowest 2018 (-18.26%). You can see that investing in stocks makes perfect sense. However it is so only over long period of time. That is why you should invest in stocks for the period of at least 5 years. For this reason on our website we consider 5 years investment period as a base for an analysis and estimates of future performance.
According to the Industry Classification Benchmark (ICB), all the stocks are classified into the following 10 basic industries.
- Basic Materials
- Consumer Goods
- Consumer Services
- Health Care
The companies within industries have some common characteristics. Those characteristics can differ amongst industries, sometimes substantially. Investors need to be aware of the industries and consider them in an investing process for many reasons.
There are three steps of top-down decision making process:
- Consider business cycle and overall market conditions.
- Diversify by industries.
- Look for the best dividend paying companies within each industry.
This way, an industry allocation is a vital part of a decision making process. If done properly, it allows reducing risk and improving investment returns through a true diversification.
When deciding on the industry allocation, the level of volatility of industry should be considered amongst other factors. Broadly speaking, the industries which tend to outperform during the economic expansion, appear to be more volatile than those resistant to the economic cycles. Less volatile industries are included in the portfolio to balance the more volatile industries. Sometimes within the same industry there are subindustries which exhibit different volatility characteristics.
Of course, the level of volatility is determined not only by the choice of industry, but also by the choice of particular stocks within the industry. If you choose the large capitalization, internationally diversified companies, risks are lower than in the case of small companies with little history of activity.
Like the economy overall, industries grow and decline in cycles. Different industries perform well at the different times. Financials and Real Estate industries declined significantly over 2008. In recent years the Oil&Gas industry have been under pressure due to the decline in commodity prices. Technology is booming at the moment.
Industries have huge impact on the investment results. This is why the dynamics of different industries should be accounted for. Monitor regularly what industries are doing well and which ones are in the decline and have potential to become a great place for your money.
It is not always clear how the economic conditions could change looking ahead and how the future could unfold for each sector. In order to reduce the investment risk, the portfolio should be invested in several industries at the same time. Being invested in about half of industries allows good enough portfolio diversification.
Industries which could succeed during the economic expansion are as follows:
Technology. It includes companies dealing with digital information. Some examples of the companies in the industry include Nokia Oyj (NOKIA) and LM Ericsson Telefon AB (ERIC-B).
Financials. It consists of banks, insurance companies, brokerages and other financial institutions. For example, companies Legal& General Group Plc (LGEN), BNP Paribas SA (BNP) and HSBC Holdings Plc (HSBC) belong to this sector.
Industrials. It consists of companies that manufacture capital goods to other industries, like construction, heavy machinery, aerospace. Examples of the companies in this sector include Vinci SA (DG), Thales Group SA (HO) and Electrolux AB (ELUX B).
Oil & Gas. It includes companies which explore and produce energy resources, for instance BP p.l.c. (BP), Total SA (TOT) and Royal Dutch Shell Plc (RDS.B).
The following sectors could be considered defensive, as they show resilience during market downturns:
Utilities. This sector consists of companies that produce and deliver water, gas, electricity, etc. Notable companies are National Grid plc (NG), Engie SA (ENGI) and Iberdrola SA (IBE).
Health Care. Companies in this sector provide health-care related goods and services. It includes the drug manufacturers, like Sanofi (SAN), Novo Nordisk (NOVO B) and Merck KGaA (MRK).
Consumer Goods. Companies within this sector produce goods and services related to basic needs of consumers, for instance Unilever (UNA), Nestle SA (NESN) and L’Oreal (OR).
Telecommunications. It consists of companies providing fixed-line telephones, wireless and other services. Examples of blue-chip companies in this sector are BT Group Plc (BT.A), Telefonica S.A. (TEF) and Vodafone Group Plc (VOD).
It should be noted that companies in defensive sectors traditionally pay higher dividends and, thus, offer great opportunities for dividend income.
Over time you will get used to the industries and companies within them. Give yourself enough time to learn about each industry in turn. Alternatively, you could start with allocating the same small amount of money to each industry and learn about several industries at a time. When you get more experienced and more confident in stock picking, you could adjust the allocation to develop your own industry balance within the portfolio.
In Eudividend website we pay special attention to the industry allocation. Please check the Home page to see the mix of industries, which is, in our view, suitable for income investors at the present market conditions. Use it as one of the factors to consider when making the industry allocation decision. Ideally you should review the industry allocation each time you take an investment decision – whether you decide to invest or divest.
Companies, paying dividends, shine out of whole universe of companies.
Dividend is a part of company’s profits, distributed to its shareholders. A dividend per share is the amount of euros or other currency each share is granted.
- Regular income for owning stock
When company pays a dividend, it means first of all that a company has money to do it. It also means that a company truly cares about its shareholders, rewards them for owning stock.
- Dividends can grow
A company pays you part of its profit and keeps the rest to ensure the future growth. Many companies increase their dividends each year. Over long term this has significant positive effect on your investment returns. Dividend growth indicates that a company has real growth. Usually managers would not increase a dividend if they are not sure there are resources to support it in the future.
- Dividend growth leads to stock price growth
Other significant advantage of a dividend growth is that over time higher dividends put pressure on stock price to go up.
There are different ways companies pay dividends and different types of dividend policies companies apply. You’ll learn about dividend policies and many other aspects of dividend investing on this website. Eudividend.com provides knowledge, tools and data for you to succeed in dividend investing.
In analyzing a company performance, the first essential piece of information to start with is the financial accounts of company. This consists of the Income Statement, the Balance Sheet and the Cash Flow Statement.
The Income Statement shows how profitable a company is over a certain period of time, the accounting period (usually one year). Its main components are Sales (Revenue), Expenses and Profit (or Loss).
Usually there are the following categories of expenses:
- Cost of Sales (Cost of Goods Sold)
- Other expenses related to core operation of company
- Financial and other expenses not related to a company’s core operation.
Profits also could be of the following types:
- Gross Profit. It is calculated as follows:
Sales – Cost of Sales
- Operating Profit which is
Sales –(Cost of Sales + Other Expenses Related to Core Operation)
- Net Profit which is
Sales – All Expenses, including non-related to core operations.
The Balance Sheet shows what are company’s Assets, Liabilities and Shareholder Equity at a certain point of time, at the end of accounting period.
They are related as follows:
Shareholder Equity = Total Assets – Total Liabilities.
The Cash Flow Statement shows how much cash went in and out of company over an accounting period, or, in other words, it shows how much cash company generated over an accounting period.